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Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions

87 Pages Posted: 7 Nov 2007  

Joseph R. Mason

Louisiana State University - Ourso School of Business; University of Pennsylvania - Wharton Financial Institutions Center

Joshua Rosner

Graham Fisher & Co.

Date Written: May 3, 2007

Abstract

Many of the current difficulties in residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings. Changes in mortgage origination and servicing make it difficult to evaluate the risk of RMBS and CDOs. We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the process of creating RMBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts. We analyze the fundamental differences between rating structured finance products like RMBS and CDOs and traditional products like corporate debt. We show that the inefficiencies of rating RMBS and CDOs are leading investors to discount U.S. markets. We conclude by providing several policy implications of our findings.

Keywords: subprime mortgage, bond ratings, collateralized debt obligations, CDO, RMBS, policy

JEL Classification: G18, G28, G21, E53, E58, A12

Suggested Citation

Mason, Joseph R. and Rosner, Joshua, Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions (May 3, 2007). Available at SSRN: https://ssrn.com/abstract=1027475 or http://dx.doi.org/10.2139/ssrn.1027475

Joseph R. Mason (Contact Author)

Louisiana State University - Ourso School of Business

2900 Business Education Complex
Baton Rouge, LA 70803
United States
202-683-8909 (Phone)

University of Pennsylvania - Wharton Financial Institutions Center ( email )

3641 Locust Walk
Philadelphia, PA 19104-6218
United States

Joshua Rosner

Graham Fisher & Co. ( email )

New York, NY
United States
917 379-0641 (Phone)

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